Duration and Convexity Prof. Ian Giddy, New
York University D
Here, represents an immediate parallel shift in interest rates. For example, = .015 corresponds to a 1.5% (or 150 basis point) parallel rise in the spot curve. The variable is the dollar change in the portfolio's value corresponding to the shift in interest rates. Accordingly, is the fractional change in the portfolio's value. Note that we use preceding superscripts 0 to indicate quantities are as of the current time 0—shifts in the spot curve are considered instantaneous. Exhibit 2 fully describes the portfolio's sensitivity to parallel shifts in the spot curve. There is no more information that we could add to the picture. What we try to do with duration and convexity is summarize the entire picture of Exhibit 2 with just two numbers. Certainly, two numbers can not describe the wealth of detail contained in a picture, so what we do is take the two most important pieces of information in the picture. Those two pieces of information are duration and convexity. Let's start with duration. The most significant information Exhibit 2 provides us about this particular portfolio is the fact that its value will decline if interest rates rise—and rise if interest rates fall. This is the information that duration conveys, along with the magnitude of such sensitivity. If we fit a tangent line to the curve in Exhibit 2, it will capture the direction and magnitude of the portfolio's sensitivity to interest rates. For small changes in interest rates, the line and the curve almost overlap.
Duration is defined to be the slope of that tangent line, multiplied by negative one. For example, in Exhibit 3, the slope of the tangent line is –2.5 (for each .01 shift in , shifts about –.025). The portfolio's duration is 2.5 years. Tangent lines are the province of calculus, so we turn to
calculus for the formal definition.
This leads to the approximation
For example, suppose a portfolio has a duration of 5 years. That portfolio will appreciate about 5% for each 1% decline in rates. It will depreciate about 5% for each 1% rise in rates. It is as simple as that. Suppose a portfolio has a duration of –2 years. The portfolio's value will rise about 2% for every 1% rise in rates. It will decline about 2% for each 1% decline in rates. Approximation [2] is the primary reason people use duration. With a single number, it summarizes a bond or a portfolio's sensitivity to changes in interest rates. Typically, a bond's duration will be positive. However, instruments such as IO mortgage backed securities have negative durations. You can also achieve a negative duration by shorting fixed income instruments or paying fixed for floating on an interest rate swap. Inverse floaters tend to have large positive durations. Their values change significantly for small changes in rates. Highly leveraged fixed-income portfolios tend to have very large (positive or negative) durations. For portfolios whose cash flows are all fixed (for example, a portfolio
of
non-callable bonds) there is a
particularly simple way to calculate duration. For such portfolios,
duration is just the weighted average maturity of the cash flows.
Specifically, assume a portfolio has fixed cash flows
,
each occurring at some time
years from time 0. Let
Now the name
"duration" should make more sense, as should the fact that duration is
measured in years! When duration is calculated in this way, it is called Take, for example, a 5-year zero coupon bond. Because it pays no coupons, its average maturity is precisely 5 years. Hence, based on the Macaulay formula for duration, the bond's duration will be 5 years. This means that a 5-year zero will appreciate about 5% in value for each 1% decline in continuously compounded interest rates based on approximation [2]. In formula [3], all present values should be
calculated using the spot interest rate for the maturity of the cash flow
it is discounting. In practice, people often calculate all present values
with a non-continuously compounded yield to maturity
where For portfolios containing instruments that do not pay fixed cash flows, such as callable bonds, mortgage-backed securities or interest rate caps, the Macaulay or modified formulas for duration will not work. For these portfolios, other means must be employed for calculating duration. Now let's consider convexity. If duration summarized the most significant piece of information about a bond or a portfolio's sensitivity to interest rates, convexity summarizes the second-most significant piece of information. Duration captured the fact that the graph in Exhibit 2 was downward sloping. It did not, however, capture its upward curvature. Convexity describes curvature. Exhibit 4 shows the best-fit parabola for the graph of Exhibit 2:
Note that the best-fit parabola does not exactly overlay the curve in Exhibit 4 because the curve is not itself a parabola. In general, the best-fit parabola will have the form
where
The best fit parabola is simply a second order Taylor series expansion. Our first-order approximation [2] now becomes a second-order approximation:
The thing to remember about convexity is that it is a metric of curvature. In Exhibit 4, the curvature of the graph bends upward (like a bowl). The convexity is positive. If the curvature bends downward (like an inverted bowl), the convexity is negative -- as is the case with many callable bonds and mortgage-backed securities. Duration and convexity have traditionally been used as tools for immunization or
asset-liability
management. To avoid exposure to parallel spot curve shifts, an
organization (such as an insurance company or defined benefit pension
plan) with significant fixed income exposures might structure its assets
so that their duration matches the duration of its liabilities—so the two
offset. This technique is called In closing, it is worth mentioning that terminology associated with the notion of duration is non-standardized. Different people will use terms in different ways. Macaulay (1938) first introduced the notion of duration as simply weighted average maturity. To him, "duration" was what we now call Macaulay duration. Later, people realized that, if Macaulay duration was calculated using continuously compounded interest rates, the result equaled the factor sensitivity [1] that is called "duration" in this article. Because people didn't typically think in terms of continuously compounded rates, this lead to the modification of Macaulay's formula, which is now called "modified duration." Other terms, including "effective duration" and "option-adjusted duration" are also used. As a rule of thumb, if someone speaks to you about some duration concept, ask what they mean. Principal source: riskglossary.com |

giddy.org | giddyonline.com | ABSresearch.com | cloudbridge.org | contact

Copyright ©2005 Ian Giddy. All rights reserved.